The world is changing fast and to keep up you need local knowledge with global context.
*This content is brought to you by Overberg Asset Management
By Werner Erasmus*
The most important driver of investment return is company earnings growth which tends to follow the business cycle. For this reason, it is important for investors to keep track of the current state of the economy and anticipate future changes in order to make informed investment decisions. Ultimately, the health of the economy impacts all businesses.
Modern investment society is largely focused on the analysis of economic data. Investors in general spend ample time trying to read, analyse and discuss economic data, with the hope of gaining insight that will provide them with the ability to forecast the market and choose the right assets, sectors and companies to invest in. With the digital age, information is everywhere. Having access to all this information is empowering but at the same time it can be very confusing and overwhelming for the general investor. Thus, the question is, does all this economic news and data so often reported on, discussed and analysed by market participants, have any real value when making investment decisions? The answer in most cases is no, not really.
Economic indicators are generally categorised as leading, lagging, or coincident, depending on whether the indicated change in economic activity will happen in the future, has already happened, or is currently underway. Investors must attempt to stay away from much noise, low impact economic data. Most economic data indicators have very little predictive power and valuable time should not be spent over-analysing them. The attention and publicity which economic data receives is disproportionately high. Firstly, this is because many economic variables are reported on and secondly, there are many different market participants (analysts and economists) who would find this data as useful information to pass on to clients.
The below pointers will assist in guiding you as an investor, as you may be inundated with economic data passing through your multiple device screens and e-mail inboxes weekly.
- Ignore data which has a frequency inappropriate to your investment horizon: Looking at high-frequency data if you are a long-term investor is a waste of time. Do not spend time looking at monetary policy commentary on interest rates or short-term predictions of exchange rates as they are often inconsequential. Look to invest in companies that will do well regardless of the economic cycle.
- Ignore most backward-looking data: Backward-looking data, often also called lagging economic indicators such as balance of trade and unemployment rate, etc. These indicators signal a change in the economy, usually after the change has taken place. They are not very useful in predicting future economic outcomes but are used as signals for conforming to the ongoing scenario. Often investors themselves can get more insight by “kicking tyres” and by talking to connections in various industries, as these individuals are at the coal face of the economy and are often the first to notice when things change on ground level. Their qualitative feedback can thus be valuable for identifying turning points in the economy ahead of the data.
- Ignore most forward-looking data: Leading economic indicators such as consumer confidence, the Purchasing Managers Index and the stock and housing market can give investors an indication of the direction the economy is moving towards, laying the foundation for an investment strategy that will fit future market conditions. Leading indicators are meant to predict changes in the economy, but they are not always accurate and often face trade-offs between accuracy, precision, and lead time in predicting future events. However, looking at several leading indicators in conjunction with other types of data can help provide information about the future health of an economy. Also, these macro-economic forecasts are often weak, therefore, be sceptical of them. They seldom forecast an economic turning point as economists are particularly prone to herding and the economic consensus is frequently wrong. Some key points to note are the following: Firstly, forecasts are always too high. Secondly, forecasts tend to lag reality, and thirdly, the following is key, analyst forecasts do not forecast, they trail. They are reactive, lagging what is actually happening by a significant amount of time because most forecasts are extrapolations of the most recent past. Forecasting is intrinsically very difficult, and the results are therefore usually poor.
Since many reported economic data has limited use and forecasts are only partially correct the question then is, what economic indicators are worth looking at?
- Business cycle and the yield curve: Investors should track the business cycle because the earnings of listed companies and hence the overall market follow it. The business cycle refers to the upswings and downswings the economy undergoes over a period. One business cycle includes both an upswing and a downswing. An indicator of the business cycle, given that it relates to aggregate economic activity, is often Gross Domestic Product (GDP). Turning points in the market earnings growth coincide very closely with turning points in GDP growth. Therefore, if we forecast GDP growth, we will be able to tell what market earnings will do. However, earnings growth in fact leads GDP growth. The market’s earnings growth is a better predictor of GDP growth than vice versa. The yield curve is a good predictor of GDP growth and one can use it to forecast market earnings growth directly. Other data such as vehicle sales, retail sales, mining, and manufacturing data can also be useful and can be read in conjunction with the outcomes of the yield curve.
- Inflation: A very important economic variable. Interest rates affect all investments, their valuations, and their attractiveness in comparison to each other. Interest rates and financial markets tend to move in opposite directions, but interest rates change only in response to changes in inflation. Inflation and inflation expectations are thus an important indicator to monitor as their movements and outlook directly affect asset prices.
In summary, most economic indicators and their market predicting ability is relatively limited and one should reduce the use of them in your investment making decisions. The majority of economic data gives insight into what has already happened in the economy as opposed to what will happen. Furthermore, refrain from using economic forecasts to attempt to predict future scenarios for the economy. We cannot predict the economy any better than we can predict the stock market. As a long-term investor, you should limit your time spent on high-frequency data and short-term forecasts. Buy stocks that will do well irrespective of the economic cycle and refrain from continuously over-analysing a vast variety of economic indicators.
- Werner Erasmus is the Regional Wealth Manager (Gauteng) and Director of Overberg Asset Management.
- Gain managed offshore exposure with exchange traded funds
- How much should you invest offshore?
- Going offshore: The How
Cyril Ramaphosa: The Audio Biography
Listen to the story of Cyril Ramaphosa's rise to presidential power, narrated by our very own Alec Hogg.